What is APY & How is it Calculated?
Interest rates shape our financial world, playing a pivotal role in critical decisions such as where to save your money. While interest rates can be a good starting point, an account's annual percentage yield, or APY, is actually a more accurate indicator of its potential earnings.
If you’ve ever compared savings accounts, trying to figure out the true benefits, then you know how daunting these tasks can be, especially when relying on interest rates alone.
However, a firm understanding of APY can dramatically simplify these comparisons. In the following guide, we’ll explore what APY means, how it’s calculated, the impact of compound interest, and more. With this knowledge, you’ll be able to effectively compare savings offers and make informed financial decisions.
An annual percentage yield is a number, expressed as a percentage, that tells you the actual amount of interest an account would earn over a year. Unlike simple interest rates, APY takes into account the frequency of compounding, which gives a more accurate measure of the return on an investment.
Savings accounts often advertise both an interest rate and an APY. In most cases, the APY is higher because it reflects the positive effects of compound interest.
The practice of compounding means that interest is added back into the balance, and future interest is calculated based on the increased amount. The effect of compounding is more significant when it happens more frequently. Therefore, two accounts with the same interest rate but different compounding frequencies will have different APYs.
Understanding how APY is calculated is fundamental to utilizing it effectively. The APY calculation essentially looks at two factors: the interest rate and the number of compounding periods in a year.
Here's how it works:
Interest Rate - The interest rate is the percentage of an investment added to an account over time. For instance, if you have $1,000 in a savings account with an annual interest rate of 1%, it would earn $10 in interest over a year.
Compounding Periods - Compounding occurs when the interest starts earning interest. For example, if the interest compounds monthly, you'll not just earn interest on the initial deposit but also on the interest accumulated the previous month. As this process continually occurs, it can make a significant difference in your account balance.
When comparing different financial products, higher APY means more potential earnings for savings and investments.
Imagine two savings accounts. Both offer a 1% annual interest rate, but one compounds annually, and the other compounds monthly. How much of a difference does that make?
For the account that compounds annually, the calculation is straightforward. A 1% interest rate on a $1,000 investment means you'd earn $10 in interest over a year.
But the interest calculation is a bit different for the account that compounds monthly.
After the first month, you'd earn interest on $1,000, just like in the first account. But for the next month, you're earning interest on $1,000 plus the interest earned in the first month. This process continues for the entire year, meaning that each month, the interest you earn is slightly more than the month before. By the end of the year, you'll have earned slightly more than $10.
The APY is essentially expressing this total interest earned in percentage terms. So, even though both accounts advertised a 1% interest rate, the account that compounds interest monthly has a higher APY and would result in a higher ending balance.
In the example above, for the account that compounded annually, the APY would be the same as the interest rate: 1%. Since interest is applied only once a year, there's no compounding within the year.
If the interest is compounded monthly, the APY would be slightly higher than 1%. To calculate this, we apply the monthly interest rate (the annual rate divided by 12) to the principal and accumulated interest each month. Over the course of a year, this monthly compounding results in an APY of about 1.01%. This may not seem like a significant difference, but when you're dealing with larger sums of money or longer periods, it can really add up.
When evaluating financial products, you may see the terms APY and APR. While they’re often confused, they are different. Annual Percentage Rate (APR) is a term used to indicate rates on debt that accrues interest, such as a loan or credit card. Annual Percentage Yield (APY) is used to indicate the return on deposits, such as a savings account, money market account, or certificate of deposit (CD).
Now that you understand APY and its significance, it's essential to understand how to evaluate APYs. Here are a few points to consider:
- Frequency of compounding - The more frequently interest is compounded, the higher the APY will be. For instance, an account that compounds interest monthly will have a higher APY than an account that compounds annually, even if their nominal interest rates are the same.
- Inflation – When evaluating an account, consider the inflation rate in addition to the APY. If the APY on your savings account is less than the inflation rate, it's effectively losing purchasing power.
- Fees - Some financial products may have fees that effectively reduce the APY. Ensure you understand any fees associated with the product and how they impact returns.
The APY offered by a financial product can either be constant (fixed) or subject to change (variable). A fixed APY will maintain the same value over time or change infrequently, while a variable APY adjusts in response to changes in the economy. Depending on the market conditions and monetary policy decisions, variable APYs can increase or decrease.
Most of the common financial products, such as checking, savings, and money market accounts, use a variable APY. However, you may come across accounts with promotional offers, such as a fixed APY up to a specific deposit limit and then a lower variable APY on additional deposits.
APYs offered on accounts often correlate to the amount of accessibility. For example, since checking accounts allow you to withdraw funds on demand, they typically pay a low APY. On the other hand, certificates of deposit (CDs) require leaving your funds in the account for a set period of time. In exchange for this sacrifice, they typically offer a higher APY.
The Truth in Savings Act requires all financial institutions to disclose an account’s APY in the documents provided when you open an account. The APY accounts for compounding over a 12-month period, but it also assumes that no withdrawals are made during the time period.
Also, the Truth in Savings Act requires disclosure of the Annual percentage yield earned (APYE) on periodic statements. This is an annualized rate that factors in both the average balance of the account and the dollar amount of dividends paid over the specified time period. Unlike APY, APYE is impacted by both deposits and withdrawals made during the time period reflected in the statement.
APY: A Vital Tool For Financial Decision Making
Knowing a financial product’s APY will help you determine the true rate of return on an investment over a 12-month period, assuming no withdrawals are made. It's more accurate than simply looking at the nominal interest rate because it considers the effects of compounding. Understanding APY and how it's calculated can help you compare various products more effectively and make sound financial decisions, which can positively impact your financial future.